Value Steps Up In Government Work
Value Steps Up In Government Work
By Jerry Grossman
Government technology companies or those delivering outsourcing and technology-based services and products to federal (and state) government markets, confront a challenging and changing marketplace in the 21st century. This marketplace provides both solid opportunities as well as identifiable risks.
Opportunities in the government markets flow from the evolution in procurement toward commercial market practices. This trend is beginning to move the focus of government officials from cost to the value of services delivered; from renting bodies (staff augmentation) to buying solutions ? more of a true outsourcing model.
Historically, most government technology companies have built businesses around the staff augmentation model, based upon a cost recovery mind-set. This model is doomed to failure or, alternatively, subpar performance as we move forward. The two principal reasons ? inability to recruit and retain sufficient quality tech talent and sluggish company valuations ? are interrelated.
The key opportunity lies in migrating quickly to more of a solution orientation, under fixed price or time-and-material contract vehicles. An increasing number of younger, emerging federal contractors are selling and implementing value-added services and solutions under these contract structures.
The solution orientation is not just a superfluous concept; it hits at the heart of the opportunities and risks present for three reasons.
First, the best technical talent is seeking to apply technology creatively to solve problems and develop solutions.
Second, solution-oriented contracts typically are fixed-price or time-and-material with budget parameters, leading to greater contractor efficiency and creativity.
Third, solutions-oriented work adds significant value to the business, providing the platform to attract and retain good people with equity participation programs.
At the end of the day, the result is most often a competitive price to the customer, combined with an attractive profit margin for the contractor. In some instances, solutions-oriented contractors are generating profit margins that are two times the level of similar companies performing under cost-reimbursable arrangements.
For high-end technology companies with the right staffing mix, consideration is again being given to technology transfer ? the application of IT/telecom know-how to non-federal markets. Attempts at commercial market development were frequent during the late 1980s and early 1990s. Successes were infrequent, leading to renewed focus on core federal markets since the early 1990s. More recently, non-federal market initiatives by federal market contractors have been more effective. These successes will be discussed more thoroughly in later columns.
The risks in this market are predominantly fourfold:
? Continuation of slow to modest growth in overall procurement budgets (generally 2 percent to 6 percent), squeezed by non-discretionary programs.
? Continuing shortages of technical talent, particularly in IT and telecom, exacerbated by the allure of .coms and challenging commercial market tech firms.
? The impact of emerging technologies upon government procurement and operations.
? Subpar market valuations due to small profit margins and modest growth outlook.
The existence of these risks has fueled industry consolidation activity, which has been strong in the middle market since early 1996. Strategic industry buyers have been joined by an increasing number of private equity groups, keeping the demand side of the market robust. Reduced industry costs of capital, for both public and private government technology companies, relative to the pre-1997 period have contributed to the pace of M&A activity. We estimate public company and private company cost of capital at 12 percent to 13 percent and 15 percent to 16 percent, respectively.
M&A deals continue to reflect acquisition multiples at the upper end of historical market ranges. (See chart at upper right) The mainstream of recent transactions reflect enterprise value (EV) to revenue multiples of six to eight times and EV/EBITDA multiples of eight to 10 times. These pricing levels infer valuations of three to six times tangible book value for the target companies, generating significant post-deal intangible assets for acquirers in non-pooling transactions. Amortization of these intangibles reduces reported earnings while increasing effective tax rates.
These effects may start to dampen acquisition prices, particularly when historically active, publicly traded buyers are involved. To the extent that analysts and investors re-direct their focus to "cash earnings" the negative effect of transaction intangibles can be mitigated. In the real world the economic earnings of a business are more accurately indicated by its cash earnings minus net income plus amortization charges.
In any event, a business-as-usual strategy will not be effective going forward.
Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va.